GAAP and IFRS

The Cost of Expensing Stock Options

FASB's decision would slash earnings of the biggest companies significantly, according to S&P. Yet employees tend to discount the actual value of o...
Stephen TaubApril 1, 2004

If yesterday’s long-expected decision by the Financial Accounting Standards Board (FASB) to require the expensing of stock options is implemented, the accounting change would retroactively reduce estimated 2004 earnings per share for the S&P 500 by 7.4 percent, according to Standard & Poor’s.

The numbers for 2003 show a drop of 8.6 percent. “A change of 7 percent or 8 percent in estimated earnings for the S&P 500 is significant, especially if investors are not fully aware of what caused the change,” said David Blitzer, managing director and chairman of the Index Committee at Standard & Poor’s. “While the numbers seem large, the expense has always been there.”

Until FASB’s move, much of the stock-options cost was reported in the footnotes, rather than the income statement.

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Employees, it seems, aren’t terribly clued in to the value of options. In a separate survey released Wednesday in response to FASB’s announcement, Watson Wyatt reported that employees at U.S. companies don’t even think options are worth all that much.

Employees discount the actual value of stock-option grants by 30 percent to 50 percent, according to the survey of nearly 650 high-income employees who received stock option grants.

Such findings could further reduce employers’ use of stock options as incentives, according to the benefits consulting firm. “It will become increasingly hard for companies to justify offering a benefit that costs one dollar while employees value it at only 50 to 70 cents,” said Ira Kay, national director of compensation consulting at Watson Wyatt. “Employers will need to find more cost-effective ways to compensate and motivate their employees.”

The amount employees discount stock option grants varies with company size and performance, as well as the employee’s investment style, according to the survey. For instance, employees in smaller organizations who more accurately know their company’s stock price tend to place larger discounts on stock option grants. Conversely, employees at better-performing companies (as measured by total returns to shareholders) and higher-income employees tend to place smaller discounts on stock options grants.

The study also noted that employees will tend to discount the value of stock option grants because they are risk-averse and less than fully diversified.

While employees might undervalue stock option grants by as much as 50 percent, they place a much higher value on shares of restricted stock, according to Watson Wyatt. The survey found that the average discount applied to restricted stock is only 18 percent. These values suggest that employers can cut their stock-based compensation costs by 20 percent to 30 percent by converting their stock-option plans to restricted stock grants.